Economic Insights - June 19 - 23, 2017

Economic Insights will not be released on July 2nd. Economic Insights will resume on July 10th, covering the month of June.

Minding the Curves: Technological change, excess capacity, and globalization help explain the weakened relationship between unemployment and inflation, or the Phillips curve. In turn, a flatter Phillips curve may shed light on why the yield curve has flattened.

Minding the Curves

The unemployment rate is declining and prospects for growth are decent. But rates on long-dated government bond have dropped along with inflation, at a time when theory suggests that inflation should be rising. The economic relationship between unemployment and inflation, or the Phillips curve, has weakened. That partially explains why the yield curve, the difference between yields on long- and short-dated government bonds, has flattened in recent months, rather than steepened.

Since the Federal Reserve (Fed) increased the fed funds rate in March and June, yields on short-dated bonds have picked up, but long-dated government bond yields have declined. The yield on the 10-year Treasury bond peaked at 2.63% on March 13th; it’s currently 2.13%. In March, the 2-to-10-year spread was 1.26%; it is now around 0.80%.

Inflation has weakened too, even as the U.S. labor market has tightened. The overall unemployment rate is 4.3%, but some metropolitan areas have jobless rates hovering around 2% or lower. Many Federal Open Market Committee (FOMC) members, including Janet Yellen, believe that the lower unemployment rate will eventually lead to wage growth, and, in turn, higher inflation. They trust that the Phillips curve is intact.

What is the Phillips Curve, anyway?

William Phillips, an economist from New Zealand, examined an inverse relationship between unemployment and inflation in a 1958 paper titled “The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957.” This inverse relationship, portrayed graphically, describes the Philips curve. Even though Phillips’s work was limited to monetary wages, two American economists, Paul Samuelson and Robert Solow, later explicitly linked unemployment and overall inflation. The slope of the Phillips curve represents that relationship. A steeper slope means that downward movements in the unemployment rate translate into pretty big gains in inflation. A smaller slope means the large drops in the unemployment do not affect inflation as much.

Structural changes in the economy translated into a flattening Phillips curve. Higher growth and lower unemployment rates may not stoke inflation as quickly as they have in the past. Overcapacity and abundant goods and commodities make it difficult to pass on any type of higher costs, including wages, to consumers.

Globalization and technological change also dampen the relationship between unemployment and inflation. Research suggests that the creation of globalized value chains may have “internationalized” inflation. When production is spread across countries, workers are competing for jobs across countries too. Internationally competitive work forces have boosted correlations of wages across borders. Wages can’t grow too fast in one country without the jobs moving to another! Globally competitive labor markets have weakened the relationship among growth, unemployment, wages, and in turn, inflation.

These structural changes mean that even as the unemployment rate declines, meaningfully higher inflation is less likely than in the past. The recent pullback in oil prices has also played a role in softer inflation.

Technology allows the U.S fracking industry to continually slash production costs despite sharp drops in prices. The reduction in oil and commodity prices isn’t going to be restored any time soon. Inflation forecasts for 2017 will likely be cut, even as chances for higher growth and lower unemployment are intact. That weaker inflation, in turn, will keep longer-dated bond yields constrained while Fed action brings up the short end of the curve.

What could bring up rates on longer-dated government bonds? One answer may be renewed confidence in the Trump administration’s ability to move a tax-reduction agenda forward. A glimmer of hope has flickered, with a higher probability that the Senate votes on health care legislation soon. If that happens, Congress could get to some sort of corporate tax cut or tax reform. Even an early-2018 passage could sufficiently boost 10-year yield levels to their March peak, despite more modest inflation.

Getting Real

Over the last year and half, China, the United States, Europe, and Japan have been in the midst of a coordinated pickup in activity and prices. Throughout 2016, reflationary recovery drove growth as the global economy bounced back from a significant adverse shock. Collapsing commodity prices and a sharply appreciating U.S. dollar hit activity, prices, and markets hard in late 2015 and early 2016. But once commodity prices bottomed in February 2016, healing began. Goods-producing sectors bounced back from recession level. Deflation turned to reflation. Headline consumer and producer prices halted their declines and started to increase. Nominal activity surged in China. Producer prices stopped falling, industrial profits soared, and nominal GDP growth accelerated to double-digit speed.

Thus far in 2017, the reflationary part of the recovery has fallen flat. Starting in March, the base effects from bottoming commodity prices rolled off the headline inflation across a broad range of countries. With oil prices falling again, downside risks to headline inflation have increased. In addition, ex-food-and-energy inflation rates in Europe and the United States have lost speed. U.S. GDP growth stumbled into a soft patch in the first quarter of 2017 as well.

But, the good news is that U.S. real (inflation-adjusted) activity is picking up again. Much of the weakness in the first-quarter GDP came from consumer spending, services spending specifically. But, the first-quarter GDP estimate may be upwardly revised, based on newly available Quarterly Services Survey data. Despite weak monthly May numbers, three-month trends in key indicators have improved. Nominal retail sales (excluding autos, building materials, food, and gas) accelerated 5.1%, industrial production picked up 3.8%. With weakening inflation, real numbers should be even better. New- and existing-home sales surprised to the upside, although housing starts stalled. Lastly, unemployment and broader measure of labor-market underutilization continue to decline.

Data for Europe and Japan have also been robust. Japanese retail sales and industrial activity have gained ground at the fastest pace since 2014. May exports and imports grew at a double-digit pace. Manufacturing Purchasing Manager Indices (PMIs) remain buoyant in Europe. The German Ifo confidence index hit a record high! With the United States out of its first-quarter soft patch, developed markets should resume their coordinated pickup in growth.

Reflating China activity drove much of last year’s reflationary recovery. That trend continued into the first quarter. Activity propelled forward, with sharp growth in easy-to-measure factors like railway freight and electricity. But, those indicators lost some speed in April and May. The tailwinds to nominal growth and profits subsided, producer price inflation declined since February’s peak.

While nominal indicators are fading, real growth remains fairly robust. But the expected continuation of the synchronized pickup in global growth is not without risks. Generally, central banks feel optimistic about the real economy, but ignore the weakening inflation at their peril. The European Central Bank and the Bank of Japan upgraded their growth forecasts. As noted above, many on the FOMC feel confident that a strong labor market will eventually lead to higher inflation. But, if central banks act too quickly, deflationary risks could easily reemerge.

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